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My investment management firm’s portfolio has a large position in the health care sector, and with AbbVie’s $63 billion takeover bid for Allergan earlier this week, it’s timely to review why we bought into this sector.

Without commenting on Allergan shares of which we own, or AbbVie which we do not, health care companies in general are noncyclical – health care consumption is stable and independent of the whims of the global economy. The world’s population is aging rapidly, and as people get older they consume more health care services. This creates a strong tailwind.

These are good businesses. In general they have solid balance sheets, above-average returns on capital, and they generate a lot of cash, which is used to pay dividends and buy back stock.

These defensive features have not mattered much lately, as we are entering the 10th year of uninterrupted economic expansion. Accordingly, these companies are significantly undervalued. How undervalued? Let’s answer that question by examining two stocks in our portfolio in closer detail:


We’ll start with McKesson. The media (mainly 60 Minutes) has likened drug distributors’ exposure to opioid lawsuits to Philip Morris International’s $150 billion tobacco settlement. Yet comparing Philip Morris to drug distributors makes no sense. The job of these well-regulated companies is to deliver FDA-approved drugs produced by FDA-approved manufacturers and sold by Drug Enforcement Administration- (DEA) approved pharmacies.

The opioid crisis in the U.S. is a true tragedy, but drug distributors are not responsible for it – an important point to remember when you read another heartbreaking article. The most likely conclusion to this fiasco is that drug distributors will either settle these lawsuits for a few billion dollars collectively (McKesson earns more than $3 billion a year) or they’ll get dismissed by the courts. (A Connecticut judge already dismissed one case.)

Wall Street estimates McKesson’s per-share earnings will grow to $18 from $14 over the next three years (our estimates are very similar). McKesson stock is trading at about $130, and in the second of half of 2019 the company will spin off Change Healthcare, in which by our estimate is worth $20-$30 a share. If you take out Change Healthcare, investors are paying around 6-7 times earnings for this stable and still-growing business. McKesson should be trading at 13 to 17 times earnings. We’ll settle for 15 and value McKesson shares at around $250-$300. If this analysis reads like a broken record, it is – despite the additional research we’ve done, our thinking on McKesson has not changed, while the company’s fundamentals have only improved.